Restricted

Chinese Banking Industry
Value Creation Study Who create shareholder
value ? Who destroy?

Eric Kuo

Shanghai,...
This study selects 18 representable Chinese banks, leveraging
their year 2012 annual reports, conducting value creation an...
Eric Kuo

Education

Professional experience

Past Presentation

Structured Finance Program
Certification, University of
C...
Agenda

1
Portfolio analysis & optimization under limited capital
2
Stress testing
3
Who create Value?

Appendix

A Why Ri...
1

Who create Value?

Eric on Chinese Banks Value Creation Analysis-en.pptx

5
1

Who create Value?

This study selects 18 Chinese banks, based on their 2012 annual
reports, trying to understand if Chi...
1

Who create Value?

The lending portfolio of these Chinese banks amounted for 42
trillion RMB and the lending portfolio ...
1

Support

This study utilizes two measures to estimate value creation :
RAROC and EP
Value Based Measures
RAROC[Risk Adj...
Support

1

The hurdle rate is estimating based on CAPM theory and it is
around 15% for Chinese banking industry
Hurdle Ra...
Who create Value?

1

The first observation: larger loan size doesn't necessary generate
more Economic Profit. One mega ba...
Who create Value?

1

Positive correlation between net revenue and bank loan size, but
low relationship between loan size ...
Who create Value?

1

Second observation: higher bank capital doesn’t necessary
generate higher return (RAROC), study show...
1

Who create Value?

The third observation: the source of value creation comes form
proper pricing. Several banks are abl...
1

Who create Value?

Overall speaking, different types of Chinese banks have their own
advantages and also face different...
1

Support

Value based metric provides banker a breakeven price to create
shareholder value
Value Based Pricing1)
Breakev...
1

Support

The term "pricing" in this study represents the margin or spread
above FTP
Pricing calculation process
Value (...
1

Who create Value?

Most of mega banks generate economic value to shareholders
except for one bank
Leading practice

Pri...
1

Who create Value?

Some national joint stock banks are focusing more on the fee
based products / services and has highe...
1

Who create Value?

Regional banks rely on higher loan margin as source of value
creation. Fee based income is still tin...
1

Who create Value?

In sum, the source of value creation are pricing and cost control.
Value creators have higher pricin...
2

Portfolio analysis & optimization under limited
capital

Eric on Chinese Banks Value Creation Analysis-en.pptx

21
Portfolio analysis

2

We dig into banks' portfolio and found that most industries /
products do generate EP to banks, exc...
Portfolio analysis

2

The reason of not be able to contribute EP is "miss-priced".
The revenue (or price) generated from ...
2

Portfolio analysis

…and these industries have higher NPL that requires more capital
and therefore need higher price to...
2

Portfolio analysis

We found some banks created EP in these non-profitable
industries through price differentiation.
Lo...
Portfolio analysis

2

We found most of pricings do not make much sense: some high
risk industries charged lower margin th...
Portfolio analysis

2

Chinese banks need to start to proactive manage their portfolio by
allocating capital to 'low capit...
Optimization example

2

This study took one bank's portfolio and perform optimization and
found that bank can enhance the...
Optimization example

5

Bank portfolio optimization example
Portfolio comparison – Pre & Post Optimization
Comments

Econ...
3

Stress testing

Eric on Chinese Banks Value Creation Analysis-en.pptx

30
3

Stress Testing

This study performed stress testing in an event of default risk
increased by 20% and concluded: the ave...
3

Stress Testing

The impacts to banks' profitability is more significant. ROE recued
by 6-8%. Mega and Regional banks wi...
3

Stress Testing

Bank's asset quality is a key factor and closely linked to the
stressed scenario performance. Low NPL b...
3

Stress Testing

In terms of industry, credit RW exceeds 100% per dollar of lending
for Electronics, Trading, Manufactur...
3

Stress Testing

Mortgage shows the most impact on the risk weight increasing,
although RAROC is still high
Stress testi...
Stress Testing

3

We further estimate economic capital and simulate banking loan
loss distribution in order to analyze if...
Stress Testing

3

To understand concentration risk, we leverage EC and generate
concentration ratio
Example

Capital conc...
3

Stress Testing

Compare to multinational banks, Banks in China has plenty of
room in improving their credit concentrati...
3

Stress Testing

We found three mega banks, three national banks have credit risk
concentration
Mega

National

Regional...
3

Stress Testing

Manufacturing and Wholesaling industry are the main source of
industry concentration risk, resulting fr...
3

Stress Testing

Moreover, these two industries have higher default risk that also
contributed to concentration risk.

C...
3

Stress Testing

We found that mega bank has higher concentration risk and higher
default risk in manufacturing and whol...
3

Stress Testing

The bigger issue for Chinese banks is that banking were not
making profit from these two concentrated i...
Recommendation

To strengthen risk management, enhance value to shareholder,
suggest Chinese banks to manage their lending...
A

Appendix
Why Risk Adjusted Performance

Eric on Chinese Banks Value Creation Analysis-en.pptx

45
A

Why Risk Adjusted Performance

A strong relationship between Chinese bank's market value and
Economic Profit based on o...
Why Risk Adjusted Performance

A

RAROC is a better performance measure that link to bank's asset
quality
ROE v.s NPL rati...
Why Risk Adjusted Performance

A

Higher correlation can be found between EP margin and asset
quality and can concluded th...
B

Appendix
Why IRB approach

Eric on Chinese Banks Value Creation Analysis-en.pptx

49
B

Why IRB approach

Current approach of credit RW doesn’t link to bank's asset quality.
No linkage between both
Current a...
B

Why IRB approach

Advance approach under Basel connects asset quality with risk
weight
FIRB approach Credit RW &
NPL
1....
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Eric on chinese banks value creation analysis

  1. 1. Restricted Chinese Banking Industry Value Creation Study Who create shareholder value ? Who destroy? Eric Kuo Shanghai, Oct 2013 1
  2. 2. This study selects 18 representable Chinese banks, leveraging their year 2012 annual reports, conducting value creation analysis to understand whether if banks' lending portfolio create value to shareholders and concluded the following : • The credit portfolio of 18 representable Chinese banks has an average 18.43% of RAROC that is higher than 15% of market hurdle rate, therefore generated economic profit to shareholders. • The first observation: larger loan size doesn't necessary generate more Economic Profit. One mega bank one, national joint stock banks and two regional banks in this survey do not generate value to their shareholders. • Second observation: larger bank capital doesn’t necessary generate higher return (RAROC). Analysis shows that higher bank capital usually has lower return • The third observation: the source of value creation comes form proper pricing. Several banks are able to charge higher rate therefore create more economic profit than his peers . 1 Value based analysis 2 Portfolio • Further, this study dig into banks' portfolio by industry and product and found that most industries / analysis & products do generate EP to banks, except eight industries/ products are not profitable. Especially, Optimization manufacturing and wholesaling industry are two main value destroyers. • Most of non-profitable industries were miss priced, this suggests Chinese banks needs to enhance their pricing mechanism. 3 Stress testing / Concentration analysis • This study performed stress testing in an event of banking portfolio default risk increased by 20% and concluded that − The average banking CAR ratio will be reduced 6-7% − ROE will decreased by 6-8% − Generally speaking only national wide joint stock banks will remain profitable • In an extreme scenario, the current bank accumulated loan loss provision can stand up to 1 in 50 event . • Taking the banks' 2012 net profit into account, Chinese banks can sustain in a 1 in 300 event • This study found that most of Chinese banks encounter industry concentration risk, especially mega banks. • Wholesaling and manufacturing industries are two major sources of concentration risk for Chinese banks, these two industries accounted for significant size of bank loan portfolio. Moreover, both industries have higher default risk than others and banks were not making profit from it. Eric on Chinese Banks Value Creation Analysis-en.pptx 2
  3. 3. Eric Kuo Education Professional experience Past Presentation Structured Finance Program Certification, University of California Irvine Since Nov 2013 - Director • Credit portfolio management customer segmentation; 2003-2004 MBA , University of Southern California 2012-Oct 2013 Roland Berger Strategy Consultants - Sr. Project Manager • Value creation through risk management and how bank prepare for the interest rate liberalization; 1994-1996 MS in Finance, National Central University; TW 2010-2011 • Experience sharing on bank process reengineering; ZheJiang CBRC 1989-1994 BA in Japanese Study, Chinese Culture University; TW 2009 Asia-Pacific risk strategy, HSBC, Hong Kong - Senior Manager Deloitte Consulting, Beijing - Project Manager 2006 1999-2008 Chinatrust Commercial Bank, Taiwan - Credit Portfolio Manager - Strategic Planning Manager 1998-1999 CosmosCommercial Bank, Taiwan - Product Manager 1996-1998 Military Service, Taiwan - Army Deputy Commander and • Enterprise risk management • Concentration risk management; Taiwan FSA and Banking CEOs meeting • Economic capital applications and challenges; ABA /APEC/ABAC – Public and private dialogue • Practitioners panel for CPM experience sharing; IACPM seminar • Sound practice of credit risk management; Vietnamese regulator and financial institution visit Eric on Chinese Banks Value Creation Analysis-en.pptx 3
  4. 4. Agenda 1 Portfolio analysis & optimization under limited capital 2 Stress testing 3 Who create Value? Appendix A Why Risk Adjusted Performance B Why IRB approach Eric on Chinese Banks Value Creation Analysis-en.pptx 4
  5. 5. 1 Who create Value? Eric on Chinese Banks Value Creation Analysis-en.pptx 5
  6. 6. 1 Who create Value? This study selects 18 Chinese banks, based on their 2012 annual reports, trying to understand if Chinese banks' lending portfolio generate Risk Adjusted Value to shareholders 5 Mega Banks 7 National-wide Joint-stock Banks 6 Regional Joint-stock Banks Who creates shareholder value? Who destroys shareholder values? Eric on Chinese Banks Value Creation Analysis-en.pptx 6
  7. 7. 1 Who create Value? The lending portfolio of these Chinese banks amounted for 42 trillion RMB and the lending portfolio has generated an estimated 18.43% of RAROC, contributing 144 billion of Economic Profit1) Basic Information [100 Mn RMB] Market Value2) NPL 1,440 57,890 Loan portfolio Net Fee Income Associated with Loan [100 Mn RMB] 20.91 ROE3) 51,991 Equity Value created by lending portfolio [%] 62,651 Net Capital Net Interest Income Avg. ROE,CAR, NPL[%] 427,152 13.21 CAR 18.43 14,512 4,851 NPL 0.95 RAROC4) 4,044 Economic Profit (Value Creation) 5) 1) Economic Profit also known as Economic Value Added 2) Data source Wind database st the end of 2012 3) ROE (Net Profit Excl. Extraordinary) (Average Weighted) 4) The RAROC estimation Included fee that related loan 5) EP is estimated by subtracting the expected loss, capital cost and operating cost related to lending from total lending net revenue Eric on Chinese Banks Value Creation Analysis-en.pptx 7
  8. 8. 1 Support This study utilizes two measures to estimate value creation : RAROC and EP Value Based Measures RAROC[Risk Adjusted Return on Capital] Loan Interest Income EP [Economic Profit] 100 FTP 50 Fee Income associated with Loan 35 Operating cost1) 20 Expected Loss2) 20 Risk Adjusted Profit 45 Loan Interest Income Credit Capital 300 RAROC [%] This study estimat ed FIRB credit capital Credit Capital= Credit RWA * target CAR Ratio 100 FTP Fee Income associated with Loan 20 Expected Loss 20 Risk Adjusted Profit 15% 35 Operating cost Using 15% as Hurdle rate 50 45 Credit Capital Hurdle Rate 45 [$] 0 RAROC >=Hurdle Ratest EP >= 0 1) Operating cost only counts the cost related to leading 2) This study is using non performing loan as substitute of expected loss due to data limitation Eric on Chinese Banks Value Creation Analysis-en.pptx 8
  9. 9. Support 1 The hurdle rate is estimating based on CAPM theory and it is around 15% for Chinese banking industry Hurdle Rate Estimation Relationship between SH Index & FS index 160 R2 91% y = 1.29x + 0.0357 High 140 Cost of equity = Risk free rate + * Market excess premium 20 FS Index return = = 0 -20 (YoY,% ) -40 -60 Low 1 Year deposit rate 3.5% 15% + * ( Avg Stock Return - 1Year Deposit ) + 1.29 * (13%-3.5%) Hurdle rate -80 -80 Low -60 -40 -20 0 80 100 120 140 SH Stock IndexReturn(YoY, %) • This study select indices since year 2001 for estimating hurdle rate of China financial service industry. and the first step is to calculate the beta based on CAPM theory • The result shows strong relationship between SH index and FS index (R square is above 91%) High • The long term hurdle rate for China financial service industry is around 15% and this study uses it as benchmarking as minimum return on capital and for the economic profit estimation. • In CAPM theory, the WACC ( can be used as minimum return on capital) requires to gauge the cost of debt, we have to skip this process due to lack of information. Eric on Chinese Banks Value Creation Analysis-en.pptx 9
  10. 10. Who create Value? 1 The first observation: larger loan size doesn't necessary generate more Economic Profit. One mega bank, one national banks and two regional banks do not generate EP to their shareholders Bank lending size v.s Economic Profit Margin per dollar of lending High 3.5 Bank Economic Profit margin comparison [%] Mega Bank Value 1.5 creation / 1.0 Avg EP margin Nation =0.34% Economic 0.5 Profit Margin 0.0 Per 2) lending -0.5 [%] alwide -1.0 Low Regio nal Value destroyer -1.5 0 Low 10,000 20,000 30,000 70,000 80,000 90,000 Lending Size1)[100Mn RMB] • This analysis uses EP margin to gauge the value creation • As shown in the left had side -0.94 0.9 graph we can observe that most 0.23 of the banks do create economic profit to their shareholders except for four banks (1 mega bank, 1 national-1.03 1.79 wide and 2 regional joint stock 0.74 banks)destroy shareholder value. • In addition, some of joint stock banks have higher EP margin 3.1 than mega banks, and this -0.88 stands for that the larger size of 0.17 bank's lending portfolio doesn’t necessary generate more value to shareholders. • Further, in the right hand side 0.34 chart depict that average speaking that natoinal-wide joint Regional stock banks have highest EP Joint-stock Banks margin. Min Value creator High Comments Max Mega bank National-wide Joint Stock Bank( Large Joint Stock Bank) 1) Bank lending size includes corporate & retail lending 2) Economic Profit margin or EP margin: represents how much value, EP can be generated per dollar of lending. The profit side also take into account of cross selling stem from lending activity; The capital is using FIRB approach that calculated by this study based on assumptions. Eric on Chinese Banks Value Creation Analysis-en.pptx 10
  11. 11. Who create Value? 1 Positive correlation between net revenue and bank loan size, but low relationship between loan size and economic profit Mega bank National-wide JS bank Regional JS bank Bank Economic Profit v.s Bank loan size Bank revenue v.s Bank loan size 500 High 4,200 High 250 Net 2,800 150 NII + Fee [100Mn RMB] Value These two mega banks demonstrate creator that higher EP contribution relative low loan size Negative EP, large loan size Economic 100 Profit (EP) 50 [100Mn RMB] 0 800 600 400 Most of nationalwide JS banks have similar loan size but EP varies -50 200 Low 0 0 Low 10,000 20,000 30,000 70,000 80,000 90,000 LoanSize1)[100Mn RMB] High • Although linier relationship between bank net revenue and loan size can be found … Low -650 0 Low Value destroyer 20,000 40,000 60,000 80,000 100,000 Loan Size1)[100Mn RMB] High • ..however, this linier correlation rule doesn’t apply to EP and loan size Eric on Chinese Banks Value Creation Analysis-en.pptx 11
  12. 12. Who create Value? 1 Second observation: higher bank capital doesn’t necessary generate higher return (RAROC), study shows that higher bank capital usually has lower return Mega 50 High 50 High Return on Capital 30 Avg.RA ROC= RAROC20 18.4% 15 5 RAROC20 [%] 15 0 Low 1,000 2,000 7,000 8,000 FIRB Credit Capital[100Mn RMB] Hurdle rate= 10 15% 5 Low Return on Capital 0 • 25 Hurdle rate3)= 15% 10 Low High return low capital usage Avg. Capital ratio=9.8% High return high capital usage 30 25 [%] Regional JS bank RAROC & Credit Capital usage per dollar of loan RAROC & Credit Capital usage High National JS bank Low 9,000 Low • • 1) Hiher risk requires more capital under Basel 3 IRB approach, therefore this study uses FIRB to gauge capital 0 8.0 High Mega banks generally have higher bank capital, but it doesn’t necessary generate higher return on capital compare to his peer joint stock banks Low return high capital usage 8.5 9.0 9.5 10.0 10.5 Credit capital per dolar of loan[%] 11.0 High Furthermore, we found that mega banks have higher credit capital requirements per dollar of lending and it means that lending business in mega banks have higher risk For the value destroyers that have negative EP, their loan portfolio not only attract more capital but also not compensate by return (Low return high capital usage quadrant) Eric on Chinese Banks Value Creation Analysis-en.pptx 12
  13. 13. 1 Who create Value? The third observation: the source of value creation comes form proper pricing. Several banks are able to charge higher rate therefore create more economic profit than his peers . Economic Profit margin analysis[%] One of the Mega banks One of national Join stock banks High value creator Higher loan pricing created value 3.84 Value created by fee income 4.10 1.36 2.03 0.92 1.56 0.84 0.90 0.76 1.50 0.06 NII Op Cost EL Profit Cap Loan Fee Total EP Cost EP One of the Mega banks -0.08 NII Op Cost No value creator Under priced 2.06 1.33 1.48 -0.45 1.64 -0.50 1.48 -0.94 -2.10 1.16 Op Cost EL Profit Cap Loan Fee Total Cost EP EP 3.05 2.26 NII 1.39 One of national Join stock banks Under priced 3.14 1.87 1.79 1.31 EL Profit Cap Loan Fee Total Cost EP EP -1.03 -1.98 0.95 NII Op Cost 1) Due to lack of expected loss (EL) information, this study uses NPL as a proxy and EL should be reflected on customer pricing. EL Profit Cap Loan Fee Total Cost EP EP Comments • Value creation in banking comes from either net interest income or fee income, banks should either charge higher loan pricing to compensate the risk taking or compensate the risk at a comprehensive manner. • The value destroyers simply under priced the risk they were taking. Eric on Chinese Banks Value Creation Analysis-en.pptx 13
  14. 14. 1 Who create Value? Overall speaking, different types of Chinese banks have their own advantages and also face different challenges Economic Profit margin analysis[%] Mega Banks 1.01 EL Fee Total EP 1.20 1.44 -0.35 0.97 0.23 1.09 1.33 -0.25 -0.97 0.76 1.08 1.52 Cap Cost 1.74 0.75 0.55 Profit 3.59 1.71 1.79 Op Cost Regional Joint Stock Bnaks 3.53 3.34 NII Loan EP National Joint Stock Banks 0.52 0.71 0.17 Leading practice Lag practice Comments • Mega banks, in general, have put significant efforts on the fee income products to compensate their lending business and this is the source of value being created from. More value can be added if mega banks can further control their credit related operational cost and asset quality. • National joint stock banks play a role model in cost control and asset quality selection, combining with their fee income business that contributed to highest EP among three types of Chinese banks • Regional joint stock banks have a outstanding loan pricing that reveal their local bank's advantage, on the other hand, regional banks require to invest more in their product innovation and services to attract fee income. 1) This study uses margin to eliminate the bank loan size effect and for compraison. All figures above are divided by corresponding loan size. 2) Capital cost stands for credit risk capital requirement multiple by hurdle rate Eric on Chinese Banks Value Creation Analysis-en.pptx 14
  15. 15. 1 Support Value based metric provides banker a breakeven price to create shareholder value Value Based Pricing1) Breakeven Pricing Explanation Operational cost 0.1% 2 Expect loss 0.5% • Several ways to estimate the cost: 1. Leverage ABC Active based costing 2. Previous average cost of particular customer 3. Benchmarking by use average cost 2 • Basel II PD*LGD • Average loss rate by collateral • Average loss rate in a particular rating grade • Cost of capital=capital usage* hurdle rate • Capital can be economic capital or based on Basel requirement • For banks not yet implement Basel, can leverage their exist rating system and apply a PD and then estimate the capital based on Basel's capital formula 4 • FTP= internal fund transfer pricing 0.4% Cost before Capital cost 1 3 1 3 Capital cost Required breakeven margin for lending 4 FTP Required lending interest rate 1% 1.5% 5% 6.5% 1) Value based pricing also can be considered as risk based pricing Eric on Chinese Banks Value Creation Analysis-en.pptx 15
  16. 16. 1 Support The term "pricing" in this study represents the margin or spread above FTP Pricing calculation process Value (risk)based pricing1) Actual (comprehensive ) pricing 2) FTP FTP + 2.6% FTP + 2.2% FTP + 0.8% FTP + 0.1% FTP + 0.2% 0.8% 1.2% FTP + 1.2% Margin 0.7% FTP Risk cost Operating cost Capital cost FTP Value Lending Guarantee Fee Deposit Actual based Pricing pricing • Value/ risk based pricing takes into risk cost, operational cost and capital cost consideration, that is useful for bankers to understand the breakeven before adding FTP and therefore bankers can price to customer in accordance with Explanation client relationship • Comprehensive pricing is the spread/ margin after FTP, that banks can compare with risk based pricing to see if relationship manager follow the pricing mechanism 1) The spread in this study is backward estimation by dividing loan size. e.g. Fee spread =net fee income/ lending size Eric on Chinese Banks Value Creation Analysis-en.pptx 16
  17. 17. 1 Who create Value? Most of mega banks generate economic value to shareholders except for one bank Leading practice Pricing analysis[%] Margin Negative EP margin (Value destroy) 6% 5% 4% 3% Breakeven pricing 1 2 0.56% 4.81% 0.31% 4.32% 0.54% 1.33% 2.27% 1.64% 5.24% 4.31% -0.94% 4.07% 1.48% 2.05% 1.46% 4.50% 0.99% Contribution of fee income Capital cost Op Cost 1% 3 EL 2 3 4 5 1.52% 3.78% 0.95% 1.31% 4 5 1 4.62% 1.74% 0.85% 2% 0% Total net EP margin1) margin Breakeven pricing Total margin Positive (Loan +Fee) EP margin (Value creation) Loan actual margin Lag practice 1.51% 3.78% 4.68% 0.9% 0.92% 1.35% Expected loss Op Cost Cap Cost • Value/ risk based pricing takes into risk cost, operational cost and capital cost consideration, that is useful for bankers to understand the breakeven before adding FTP and therefore bankers can price to customer in accordance with Explanation client relationship • Comprehensive pricing is the spread/ margin after FTP, that banks can compare with risk based pricing to see if relationship manager follow the pricing mechanism 1) Total net margin=lending margin + Fee margin Eric on Chinese Banks Value Creation Analysis-en.pptx 17
  18. 18. 1 Who create Value? Some national joint stock banks are focusing more on the fee based products / services and has higher EP margin than his peers Leading practice Pricing analysis[%] Breakeven pricing Total net EP margin margin Negative Margin Breakeven EP margin (Value pricing 6% 5% Lag practice 1 destroy) Total margin (Loan +Fee) Highest fee income contribution 4% 0.92% 4.07% 0.31% 3.93% 0.97% 5.98% 1.79% 4.27% 0.9% 4.24% 0.07% 4.0% -1.03% 0.61% 2 Capital cost 4.9% 2.14% 1.23% 3.98% 1.32 3.76% 1.32% 1.69% 0.74% 3 1.24% 2.96% 0.58% 1.14% Loan margin 4 Generate positive loan EP margin 3% Op Cost 2.03% 1.39% 4.18% 0.76% 1.36% 3.37% 5 2% 0.74% 1.27% 6 0.95% 1% EL 0% 1 Explanation 2 3 4 5 6 7 7 4.17% 1.67% 1.55% 1.48% 2.06% 1.48% 5.03% Expected loss Op Cost Cap Cost • Different banks have their own strategy, some banks focus on operating cost control, some are focusing on charging the right lending price and some choose on fee income generation Eric on Chinese Banks Value Creation Analysis-en.pptx 18
  19. 19. 1 Who create Value? Regional banks rely on higher loan margin as source of value creation. Fee based income is still tiny Leading practice Pricing analysis[%] Breakeven pricing Lag practice Total net EP margin margin Margin 1 8% 6% 2 Negative EP margin (Value destroy) Generate positive loan EP margin 5% 3.54% 0.16% 6.1% 1.31% 7.63% 3.1% 3.94% -0.58% 3.66% -0.88% 4.1% 0.84% 0.59% 1.34% thin fee income contribution 7% 3.37% 1.44% Breakeven pricing Total margin 3 2.30% 1.43% 4.53% 0.80% 4 4% (Loan +Fee) 0.90% 2.30% 1.59% 4.79% 1.88% 1.63% 4.52% 1.01% 3% Capital cost 2% 1% 0% Explanation 5 Op Cost Loan margin 6 EL 1 2 3 4 5 6 2.17% 1.53% 4.54% 0.83% 1.49% 3.27% 0.58% 1.21% Expected loss Op Cost Cap Cost • Half of regional banks were able to charge their loan price above the breakeven pricing that demonstrates these banks have more bargaining power while faced the competition of mega banks and national banks. Eric on Chinese Banks Value Creation Analysis-en.pptx 19
  20. 20. 1 Who create Value? In sum, the source of value creation are pricing and cost control. Value creators have higher pricing, better internal operational cost control and asset quality. 2012 Chinese Banking Economic Profit Tree[%] 3.45% 3.15% 3.40% 1.14% 1.11% 1.14% 2.23% 1.77% NII (Lending margin) Risk adjusted profit margin 2.05% 1.81% Fee 0.70% Value creation (Positive EP) EP margin 0.61% Value Banking destor average (Negative EP) 1.68% Operating cost 0.87% 0.34% Capital cost rate Value destor (Negative EP) 0.95% Expected loss 91.65% -0.93% Value creation (Positive EP) 1.32% Banking average 1.44% Value creation (Positive EP) 1.63% 1.48% Value Banking destor average (Negative EP) Credit risk 103.38% 93.72% Value creation (Positive EP) Value destor (Negative EP) Banking average weigh) 10.5% of CAR 15% of hurdle rate •The core to value generation is the pricing, this includes net interest income and fee based product. Bankers can yield Explanation lending and gain from fee based products, as long as bankers stick to value/risk based pricing •On the cost side, we found value creation group has better operating cost control and better asset quality that differentiate themselves than the value destroy group Eric on Chinese Banks Value Creation Analysis-en.pptx 20
  21. 21. 2 Portfolio analysis & optimization under limited capital Eric on Chinese Banks Value Creation Analysis-en.pptx 21
  22. 22. Portfolio analysis 2 We dig into banks' portfolio and found that most industries / products do generate EP to banks, except eight industries/ products cannot generate economic profit RAROC analysis by industry[%] Avg. RAROC=18.4% 200% 152% RAROC lower than 119% 15% of hurdle rate 53% 48% 42% 33% 26% 24% 40% 34% 17% 32% 26% 13% 25% 24% 23% 17% 14% 12% 10% 7% 6% 3% 1% Economic profit analysis by industry / products[100Mn RMB] 487 305 295 54 58 40 3 Negative EP 589 297 187 7 389 134 23 100 184 3 25 -8 -7 -47 0 -10 -4 -595 -1,069 Comments Tourism Wholesaling Manufacturing Computer Post & Telecom Others Credit card Off shore Trading Accommodation Electronics Constructure Education Transportation Leasing Real estate Mortgage Personal lending Mining Engery Service Public infrastructure Environmental Agriculture Financial Service Guarantee • Most banks provide portfolio breakdown and this study further diagnose portfolio performance and concludes: 1. Most industries / products do generate EP 2. Among products, Guarantee has highest RAROC 3. Mortgage, personal lending product contributed highest EP to the banks, benefiting to low capital requirement1) and low historic loss 4. Manufacturing & wholesaling industry were two value destructors, both of them destroy shareholder value by 166.4 Bn RMB 5. This study didn’t find credit card create value 1) Retail products general has lower capital requirement under Basel Accord and even PD, LGD, EAD are all identical, corporate lending attracts higher capital ; Eric on Chinese Banks Value Creation Analysis-en.pptx 22
  23. 23. Portfolio analysis 2 The reason of not be able to contribute EP is "miss-priced". The revenue (or price) generated from these industries lower than their required breakeven price… Pricing analysis [%] Actual pricing Value/ risk based pricing (Breakeven price) 6.32 5.93 5.18 5.30 5.06 4.71 4.61 4.64 4.53 4.57 3.67 4.55 4.05 2.91 2.54 2.58 1.92 2.06 3.33 3.18 4.31 4.53 4.55 3.62 4.36 4.47 4.69 4.98 4.80 4.68 4.23 4.65 4.30 5.81 5.22 4.50 4.38 3.75 3.53 3.71 3.54 3.34 3.59 3.54 4.46 5.40 3.15 3.23 3.26 3.26 2.32 1.73 Tourism Wholesaling Manufacturing Computer Post & Telecom Others Credit card Off shore Trading Accommodation Electronics Constructure Education Transportation Leasing Real estate Mortgage Personal lending Mining Engery Service Public infrastructure Environmental Agriculture Financial Service Guarantee Comments • The white bar stands for the net revenue generated from industry and the light blue bar represents the breakeven price. • The unprofitable industries/ products were under priced and not meeting breakeven price requirement therefore, destroy shareholder value. • For example, manufacturing industry has an average price of 4.5% per dollar of loan, however, to generate EP in this industry banks need to charge above 5.81% Note : The actual price listed above includes NII and Fee income and divided by its corresponding loan amount,in order to gauge the revenue generation per dollar of lending. Eric on Chinese Banks Value Creation Analysis-en.pptx 23
  24. 24. 2 Portfolio analysis …and these industries have higher NPL that requires more capital and therefore need higher price to compensate the risk NPL FIRB Risk Weight NPL(%) Credit Risk Weight (%) 2.5 160 140 2.0 120 RW=94% 100 1.5 80 1.0 60 40 0.5 20 0.0 0 Tourism Wholesaling Manufacturing Computer Post & Telecom Others Credit card Off shore Trading Accommodation Electronics Constructure Education Transportation Leasing Real estate Mortgage Personal lending Mining Engery Service Public infrastructure Environmental Agriculture Financial Service Guarantee Comments • In our estimation, the average FIRB based risk wegiht is around 94%, that means that 100 dollars of lending equals to 94 dollars of risk weighted asset. Generally speaking, higher NPL requires more Risk weight as shown in the graph. • For those industries/products who have lower than 15% of RAROC reveal higher NPL and thus higher risk weight than average. • Therefore, the core reason of why these industries do not profitable is still pricing, banks in this study, in general, do not price at risk or price at value Eric on Chinese Banks Value Creation Analysis-en.pptx 24
  25. 25. 2 Portfolio analysis We found some banks created EP in these non-profitable industries through price differentiation. Loan margin Economic profit margin benchmarking by non profitable industry Total net margin ( %) EP Margin ( %) Non-profitable industry average EP margin Off shore Credit card Highest EP mergin among banks -0.08 -0.12 1.13 -0.50 Post & Telecom 2.53 -0.50 2.69 -1.31 Wholesaling -1.94 Tourism -1.96 0.93 -0.56 -1.96 3.3 1.0 3.2 1.4 4.7 0.9 4.2 3.3 3.0 0.3 3.3 -1.11 Computer Non-profitable industry average pricing 2.2 2.08 -0.41 Others Manufacturing Fee margin 1.0 4.3 3.3 3.4 Highest pricing among banks 0.9 4.4 3.3 3.0 0.3 1.6 7.2 5.5 0.6 4.2 3.6 0.3 3.3 3.0 3.7 1.1 4.5 3.5 0.7 3.9 3.2 2.3 6.0 0.3 7.1 6.9 3.6 0.6 4.2 3.0 3.3 0.3 • Some banks in this survey still can generate EP in these non-profitable industries through price differentiation. Comments • For example, the average EP margin of manufacturing industry in the market is -1.31, however, one bank can generate 0.93 % of EP margin through higher loan pricing than market average (6.9% v.s 3.4% of loan margin) • This example proves that bank definitely need to enhance their pricing approach and stick to the value / risk based price in order to add value to shareholders Eric on Chinese Banks Value Creation Analysis-en.pptx 25
  26. 26. Portfolio analysis 2 We found most of pricings do not make much sense: some high risk industries charged lower margin than lower risk industries'. Pricing comparison by industry Value/ Risk based breakeven pricing by industry NPL & Total net margin by industry High risk low margin risk Wholesaling Manufacturing Computer High risk high margin [%] 1.0 Others Low risk low 0.8 margin Constructure 0.4 Leasing Off shore 0.2 Engery 0.0 0.0 Low risk Accommodation Electronics Real estate Post & Telecom Transportation 0.6 Low risk Credit card Avergae NPL= Credit card 1.2 Mining Computer Manufacturing 1.4 Tourism 1.4 Wholesaling 1.6 Trading 1.6 NPL High risk 2.4 Avg. total margin4.53% High 2.4 Low risk high margin 0.95% Accommodation [%] 1.0 0.95% 0.4 0.2 Guarantee 6.0 High risk • Low correlation between total margin and NPL can be found in the above graph. • Take manufacturing industry as an example that average NPL is 2.33%, much higher than survey banks' NPL average, but the average margin received is lower than banking industry average Avergae NPL= Education Electronics Personal lending Transportation Real estate Post & Telecom Constructure Off shore Mortgage Service Leasing Environmental Mining Agriculture Public infrastructure Engery Financial Service Guarantee 0.6 Mortgage Financial Service 3.5 4.0 4.5 5.0 5.5 Total margin (NII+Fee) [%] Others 0.8 Personal lending Education Public infrastructure Service Environmental Agriculture NPL 1.2 Tourism Trading Low 0.0 risk 0.0 Low risk 2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0 6.5 High risk Breakeven [%] • The proper pricing for manufacturing industry is at least 6.32% based on risk based pricing mechanism. • If bank can charge higher margin than breakeven, it will contributes more value to shareholders and enhance bank's ROE Eric on Chinese Banks Value Creation Analysis-en.pptx 26
  27. 27. Portfolio analysis 2 Chinese banks need to start to proactive manage their portfolio by allocating capital to 'low capital usage high return' industries and enhancing their pricing mechanism Industry average default probability & loan size S& P Rating 5.5 High risk B+ Relative high risk Manufacturing Agriculture Environmental 2.0 Tourism Credit card 3.0 Probability of default 2.5 BB- 2.12 [%] BB 1.21 1.0 BB+ 0.71 0.5 Low Trading Others Accommodation Education Avg PD= Electronics Personal lending Post & Telecom 2.1% EP 1.0 margin 0.5 [%] 0.0 0 10,000 20,000 Loan size [100 Mn RMB] Transportation Education Constructure Leasing Real estate Personal lending Electronics Accommodation 0.0 Off shore Credit card Post & Telecom Relative low risk -1.5 • This study further estimate the average probability of default by each industry and found that Wholesaling and Manufacturing industry have higher default risk in our survey and surveyed banks were concentrated in these two industries. Value destroy Low capital usage Trading Value destroy high Others capital usage Computer Manufacturing Wholesaling Tourism Low -2.0 90,000 High Value creation high capital usage Service Public infrastructure Mining Engery Mortgage Constructure Real estate Leasing Off shore Mortgage Service Transportation Mining Public infrastructure Environmental Engery Financial Service Agriculture Guarantee Low Value creation Guarantee Low capital usage Financial Service Wholesaling 3.5 risk Average capital usage=9.8% High 4.5 Computer 3.76 Industry average EP margin & Capital usage 2 Low 3 4 5 6 8 9 10 11 12 13 14 15 16 Capital usage per unit of loan[%] High • Higher concentration risk weren't compensated by return generated by these two industries. • We suggest banks should start to manage their portfolio by reallocating more resources to high return low capital usage industry and in the meantime enhancing pricing for value destroy industries Eric on Chinese Banks Value Creation Analysis-en.pptx 27
  28. 28. Optimization example 2 This study took one bank's portfolio and perform optimization and found that bank can enhance their EP, ROE through this capital allocation process Performance comparison – Pre & Post Optimization Optimization FIRB Capital Usage (100 Mn RMB) Loan Size (100 Mn RMB) EP (100 Mn RMB) Capital Adequacy Ratio +7.0% 0.0% 29,473 2,953 +8.8% 31,523 +1.0% +15.0% 2,953 14.07% 413 • One important • restriction is we try to enhance EP by not increasing current credit capital usage Through optimization, the portfolio is adjusted the proportion of lending based on risk and return. • In this example the lending business grows ROE 1) 18.4% 20.1% 14.21% 475 • Economic profit improved by 15% is • Improved EP further strengthen bank's CAR • Also enhanced ROE 1)Optimized ROE= Profit+increatmental EP / equity Eric on Chinese Banks Value Creation Analysis-en.pptx 28
  29. 29. Optimization example 5 Bank portfolio optimization example Portfolio comparison – Pre & Post Optimization Comments Economic Profit 115 110 Transportation Pre-Optimization • A meaningful optimization requires Post Optimization 105 100 reasonable restrictions to prevent Transportation Personal lending 75 70 from allocating all bank's capital to the highest sector. 65 60 55 Real estate Personal lending Service • Most banks have their own practices Real estate 50 45 40 in the setting of restrictions, Service Energy Environmental Environmental 35 30 generally speaking bank needs to Energy consider market size of industry, Financial service 25 Guarantee Construction Guarantee Construction 20 Mining Mining 15 Education Education 10 5 Financial service Others Telecom Telecom 0Accommodation Accommodation 50 100 150 reducing exposure in low return Manufacturing Manufacturing Others Wholesale & retailing -5 0 GDP growth rate, possibility of 300 500 550 industries, forward looking expected Wholesale & retailing 600 650 700 750 800 Capital 850 return ..and so forth 900 Eric on Chinese Banks Value Creation Analysis-en.pptx 29
  30. 30. 3 Stress testing Eric on Chinese Banks Value Creation Analysis-en.pptx 30
  31. 31. 3 Stress Testing This study performed stress testing in an event of default risk increased by 20% and concluded: the average banking coverage ratio reduced by 17% and CAR ratio decreased by 6-7% Current Impact to banking under stressed scenario Portfolio Probability of default (%) 1.69% NPL Ratio(%) 0.76% Stressed scenario Coverage Ratio (%) Portfolio average Credit RW 344% 92% -17% Regional Joint stock bank 0.91% 286% 97% 2.23% 1.01% 283% 96% -17% 2.68% 1.68% 1.21% 0.76% 235% 0.91% 237% 15% +7% -7% 14% 85% -17% 2.02% -6% 17% 103% 284% National Joint stock bank Comments 18% +6% 2.03% Mega bank CAR(%) 17% +7% 90% -6% 16% • This study estimates impacts of stressed scenario when banks' average PD increased by 20%. • Banking industry in China will remain solvent but CAR will be tightened Eric on Chinese Banks Value Creation Analysis-en.pptx 31
  32. 32. 3 Stress Testing The impacts to banks' profitability is more significant. ROE recued by 6-8%. Mega and Regional banks will no longer generate positive EP. Current Impact to banking under stressed scenario Portfolio Probability of default (%) 1.69% Stressed scenario EP margin per dollar of loan1) RAROC 16.76% Regional Joint stock bank 2.23% 14.29% -143% 18.43% 0.23% -17% 2.68% 1.68% 14.32% 20.91% -132% 19.28% 21.15% 0.74% -13% 2.02% -8% -0.07% 23.37% National Joint stock bank -6% -0.07% 17.31% Mega bank 19.59% 0.17% -15% 2.03% ROE 20.33% -32% 0.50% -6% 19.81% • While banks will still be sustained in this stressed scenario, the profitability of banks face significant challenge. Comments • RAROC reduced by 13% -15% and only national joint stock banks will maintain above 15% of hurdle rate. • Loan portfolio will no longer contribute EP for mega and regional banks. • Overall impact to bank ROE is expected a 6-8% of reduction Eric on Chinese Banks Value Creation Analysis-en.pptx 32
  33. 33. 3 Stress Testing Bank's asset quality is a key factor and closely linked to the stressed scenario performance. Low NPL banks perform better than high NPL banks RAROC analysis under stress testing 20.33% Size = NPL in 2012 14.29% Regional High Hurdle rate=15% 14.32% Mega Comments National 45 40 • Average speaking, National joint stock banks have better performance: 1. One mega bank, two national banks and three regional banks will not be able to perform a return above hurdle rate 2. Lower NPL Better Return Overall speaking, these banks suffer higher NPL and we can conclude that if banks have a better asset quality under normal economic situation, they will have more chances to survive and out perform their peers. 35 30 RAROC 25 [%] 20 15 10 5 Low 0 Higher NPL Worse Return Eric on Chinese Banks Value Creation Analysis-en.pptx 33
  34. 34. 3 Stress Testing In terms of industry, credit RW exceeds 100% per dollar of lending for Electronics, Trading, Manufacturing and Wholesaling industry in the stressed scenario Stress testing RAROC & RW analysis High 55 Normal Environmental 50 Comments Environmental Mortgage Mining Personal loan 25 Real estate Leasing [%] 15 risk Construction Real estate Transportation 20 Credit card weight Transportation Electronics Electronics Construction Trading Off shore 10 1. Low 2. Manufacturing below Manufacturing Wholesaling Wholesaling Hurdle rate -5 0 Low 50 60 70 RAROC decreased below hurdle rate in credit card, off shore business, trading, manufacturing and wholesaling Trading Credit card 0 Four industries will have an average RW exceeds 100%, they are electronics, trading, manufacturing and wholesaling Off shore Return 5 • In an economic downturn, both of the NPL and the RWA will be increased and results in lower return on capital, the study shows: Higher Mining Others Personal loan Others Mortgage Leasing 30 RAROC Stressed 80 90 100 130 Risk Weight [%] 140 150 160 High Eric on Chinese Banks Value Creation Analysis-en.pptx 34
  35. 35. 3 Stress Testing Mortgage shows the most impact on the risk weight increasing, although RAROC is still high Stress testing RAROC & RW analysis High 55 Normal Environmental Comments Stressed 50 30 Mining Personal loan Mortgage Others Real estate Leasing 25 RAROC Transportation Construction Electronics 20 [%] Mining Personal loan Others Real estate Transportation Construction Leasing Mortgage 1. Among the portfolio, Mortgage has a significant impact and increased by 11% of risk weight 3. Environmental industry is next to mortgage and increased by 9% 4. Electronics Risk weight in general, will be increased by at least 6% 2. High return The significant RW increased is due to both of mortgage and environmental have a relative low PD (NPL).When PD increased in the stress testing, RW boost outpace others Trading 15 Off shore Trading Credit card 10 Off shore Credit card Lower Return Manufacturing 5 Wholesaling 0 Low • The graph on the left hand side shows the risk weight change before and after stress testing and found that : Environmental Manufacturing Wholesaling -5 0 100 101 102 103 104 105 106 107 108 109 110 111 112 Risk weight impact under stress testing [%] Eric on Chinese Banks Value Creation Analysis-en.pptx 35
  36. 36. Stress Testing 3 We further estimate economic capital and simulate banking loan loss distribution in order to analyze if banks can survive in an extreme economic turn Loss distribution for 18 surveyed banks Probability Loss Probability(%) Comments • 9 This study simulate 18 banks' portfolio and draw loss distribution, trying to diagnose if the accumulated loan loss provision is enough for banks to sustain in extreme stressed scenario 1. It shows that the current accumulated 1,149 Bn RMB provision is able to cover 63% of stress scenarios. There is a 2% of chance (1 in 50 year) that the banking industry will face a stress loss that will wipe out all provision. 2. 28 Only 0.3% of probability that banks will suffer even extreme loss at 2,249 Bn RMB that will erode both of provision and profit. Under this scenario bank still remain capitalized 63% of occurrences 8 1 3 1 in 50 year 2% 2 1 1 in 300 year 0.3% 0.001% Loss (Bn RMB) 0 0 1,149 18 banks' total Loan provision=1,149 Bn RMB 18 banks' Net profit = 1,087 Bn RMB 42,715 8,5016 2,249 Capital =6,265 Bn RMB Tail risk Loan size of 18 surveyed banks= 42,715 Bn RMB Eric on Chinese Banks Value Creation Analysis-en.pptx 36
  37. 37. Stress Testing 3 To understand concentration risk, we leverage EC and generate concentration ratio Example Capital concept 2,953 Book capital 85 • Accounting concept What bank has on the book 306 2,647 Regulatory capital EC 75 60 • Regulatory requirement • Under Basel, Credit Capital estimated based on – PD – LGD – EAD • A customized method and depends on bank's credit portfolio mix and considering the correlation of portfolio Minimum requirement to compliant RC (FIRB Divrsification Credit Capital) Effect The risk capital bank should hold for the risk taking activity Concentrat ion ratio EC over RC = EC 89% • If EC less than regulatory capital (RC), it is considered there is a diversification effect, or concentration risk on the other hand. • The example above demonstrates EC is 89% of RC. 11% lower than regulatory requirement due to bank's portfolio is relative diversified Eric on Chinese Banks Value Creation Analysis-en.pptx 37
  38. 38. 3 Stress Testing Compare to multinational banks, Banks in China has plenty of room in improving their credit concentration risk Unit[USD Billion] Concentration risk Benchmarking Deutsche Bank ING One National One Mega Bank Bank NedBank One Regional Bank 118.0 113.5 30.3 23.0 22.6 16.9 13.0 9.7 2.8 AIRB Credit Capital EC over RC Ratio3) EC 43% AIRB Credit Capital 43% EC 2.2 2.0 AIRB Credit Capital 71% EC FIRB Credit Capital 73% EC FIRB Credit Capital EC 103% 2.1 FIRB Credit Capital EC 89% 1) DB, ING and Ned Bank capital information is at year2010 DB & ING are multinational banks while as Nedbank is relative localized and concentrated in South Africa 2) exchaneg rate at 1USD =RMB 6.1 3) EC over RC is used in this study as concentration risk measure, it is considered that of this ration exceeds 100% then there is concentration risk concern Eric on Chinese Banks Value Creation Analysis-en.pptx 38
  39. 39. 3 Stress Testing We found three mega banks, three national banks have credit risk concentration Mega National Regional Concentration risk analysis EC= RC 4.0 Mega Bank Comments EC>RC EC< RC • This study utilize the EC model to analyze banks portfolio diversification / concentration effect, and found that : 3.5 3.0 1. Three mega banks and three national banks have concerns of concentration risk that their EC are 4% to 15% higher than regulatory capital requirement. This results reflect that most of mega banks were concentrated in certain industries as a means to support government policy 2. Regional banks in our survey were more diversified , further analysis needs to be done to explore the reason 2.5 National Bank 2.0 1.5 1.0 Regional Bank 0.5 0.0 -20 -15 -10 -5 Diversification 0 5 10 15 Concentration 20 Eric on Chinese Banks Value Creation Analysis-en.pptx 39
  40. 40. 3 Stress Testing Manufacturing and Wholesaling industry are the main source of industry concentration risk, resulting from their significant size of lending. Top 6 industry concentration risk analysis Mega Bank Concentration ratio1) [%] 200 Wholesaling 150 Real estate 100 Electronics 50 Avg. Concentration Ratio Manufacturing Transportion Mortgage 100.6 0 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 200 Natio nal Bank Regio nal Bank 150 Transportation Wholesaling 100 Construction Manufacturing Mortgage 50 Real estate 0 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 200 150 Wholesaling 100 50 Trading 0 3 Low 4 5 6 7 Manufacturing Real estate Leasing 95.1 Comments • We found that mega bank group has a concentration ratio almost equal to 100%, that means that the FIRB credit capital almost represent their economic capital. • Second, national bank group and regional bank group has 5% of diversification effects • All Chinese banks have industry concentration risk concern in Manufacturing and Wholesaling industry 93.9 • It seems that Real estate industry and mortgage are not a concern of concentration at year 2012. 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 High As % of total loan portfolio 1) EC over RC 2) Part of regional banks classified mortgage into personal lending, therefore this study is not be able to estimate average mortgage concentration measure for mortgage Eric on Chinese Banks Value Creation Analysis-en.pptx 40
  41. 41. 3 Stress Testing Moreover, these two industries have higher default risk that also contributed to concentration risk. Comments Industry Concentration Analysis High Size of bubble = average industry PD 170 160 150 5.18% Wholesaling 140 Manufacturing 130 Concen- 120 tration 110 ratio 100 [%] 90 80 70 Trading Others Concentration 60 • We found three industries have concentration risk concerns, and suggest Chinese banks to adjust their current portfolio 0.85% Mortgage Real estate Transportation Off shore Electronics 50 40 MiningLeasing Environmental 0 Low 2 3 Low 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 % of total loan portfolio • Higher default risk represents larger uncertainty and it will attract more unexpected loss in the economic capital simulation and resulted in more capital requirement. Hence, higher concentration • Mortgage product is more diversified due to lower default risk and large amount of individual customers High Eric on Chinese Banks Value Creation Analysis-en.pptx 41
  42. 42. 3 Stress Testing We found that mega bank has higher concentration risk and higher default risk in manufacturing and wholesaling compare to others Top 6 industry concentration risk analysis Mega Bank =Average PD Concentration ratio [%] 200 5.97% Wholesaling 150 100 4.77% Real estate 50 Transportion Electronics Manufacturing Mortgage Average portfolio PD 2.23% 0.91% 0 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 200 Natio nal Bank Regio nal Bank Wholesaling 150 3.09% Transportation 3.81% 100 Construction Manufacturing Mortgage 0.45% 50 Real estate 0 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 200 150 4% 3.04% Wholesaling 100 50 Trading 0 3 Low 4 5 6 1.68% Manufacturing Real estate Leasing 1.69% Comments • Further breakdown the analysis by mega bank, national and regional banks and found that the default risk in manufacturing and wholesaling industries are higher • In terms of mortgage, mega bank has an average 0.91% of low default that mitigate the concentration risk , even though the mortgage accounted for 19% of loan portfolio. 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 High As % of total loan portfolio Eric on Chinese Banks Value Creation Analysis-en.pptx 42
  43. 43. 3 Stress Testing The bigger issue for Chinese banks is that banking were not making profit from these two concentrated industries. Top 6 industry concentration risk analysis High concentration risk EP margin[%] 4 Mega Bank 2 Low concentration risk Value creation Real estate 0 -2 Transportion Electronics Wholesaling 4 5 4 Natio nal Bank 6 7 Value creation Mortgage 0 Construction -2 0.74% Real estate Wholesaling 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 4 Value creation 2 Trading 0 Leasing 0.17% Real estate Wholesaling -2 Manufacturing Value destroy -4 3 Low Manufacturing Value destroy -4 Regio nal Bank 0.23% 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 Transportation 2 Mortgage Value destroy Manufacturing -4 3 EP margin (%) 4 5 6 7 Comments • It is unlikely banks can prevent from industry concentration risk due to that if national GDP is already concentrated in certain industries • Therefore the issue to be discussed is how we can create value out of it. • The analysis found that Chinese banks were incapable of making profit in Manufacturing and Wholesaling industry. This brings more concerns on their internal management 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 High As % of total loan portfolio Eric on Chinese Banks Value Creation Analysis-en.pptx 43
  44. 44. Recommendation To strengthen risk management, enhance value to shareholder, suggest Chinese banks to manage their lending business in a more proactive ways by implementing the following Key actions Explanation Value based management • Implementing value based performance metrics into customer/ product level. • Performing regular analysis and identify key value customer group and as a foundation of credit portfolio management Credit portfolio management • Managing portfolio at forward looking basis and embedding portfolio relocation into the annual budgeting process, the results become bank's KPI • Open discussion on the risk appetite to clarify where to grow , where to stop 3 1) 1 2 Reco mmen dation Repositioning and customer segmentation • Repositioning market and target customers ban has advantage. • Segmented customer by industry and size of customer and fully understanding customer needs to deepen relationship with clients and therefore become customer's core bank : Economic Profit :Risk Adjusted Return on Capital Eric on Chinese Banks Value Creation Analysis-en.pptx 44
  45. 45. A Appendix Why Risk Adjusted Performance Eric on Chinese Banks Value Creation Analysis-en.pptx 45
  46. 46. A Why Risk Adjusted Performance A strong relationship between Chinese bank's market value and Economic Profit based on our empirical test Chinese banks market value v.s Economic profit 15,000 Comments R2 =77% High 14,000 y = 19.623x + 246844 Mega National Regional 13,000 12,000 11,000 Market value1) 10,000 [100 Mn RMB] • EP takes into account of shareholder reward, and therefore it is considered as better measure to gauge value creation • We regressed Chinese banks market value and estimated EP and found strong correlation that implies that higher EP will has higher market value 9,000 3,000 2,000 1,000 Low 0 -100 -50 Lower 0 50 100 150 200 250 300 350 400 650 Economic Profit2) [100 Mn RMB] High 1) Data source Wind database, end of 2012 2) Source 2012 bank annual report, EP =Net profit – bank capital * 15% of hurdle rate Eric on Chinese Banks Value Creation Analysis-en.pptx 46
  47. 47. Why Risk Adjusted Performance A RAROC is a better performance measure that link to bank's asset quality ROE v.s NPL ratio R2 =5% y = -2.5921x + 0.2273 25 24 [%] R2 =33% y = -25.049x + 0.4256 Mega National Regional 30 23 ROE RAROC v.s NPL ratio High 50 High 26 25 22 RAROC20 21 [%] 20 15 19 10 18 5 17 Low Low 0 1 0.5 0.6 0.7 0.8 0.9 1.0 1.1 1.2 1.3 1.5 Low NPL [%] High • Regression result doesn’t support relationship between ROE and Chinese banks' NPL 0.0 Low 0.6 0.7 0.8 0.9 1.0 1.1 1.2 1.3 1.4 1.5 NPL [%] High • On the other hand, higher correlation (or R square) can be found between RAROC and NPL Eric on Chinese Banks Value Creation Analysis-en.pptx 47
  48. 48. Why Risk Adjusted Performance A Higher correlation can be found between EP margin and asset quality and can concluded that EP is a good indicator of value creation Industry-wide EP margin v,s NPL ratio High4.5 4.0 3.5 Guarantee FS 3.0 2.5 EP margin R2 =69% y = -2.0132x + 0.0202 Portfolio breakdown of one public listed bank- EP margin v.s NPL High 3.5 Agriculture R2 =91% Mining 2 y = -2.2976x + 0.0235 Guarantee 3.0 2.5 Agriculture Service 2.0 1.5 EP Environmental Public Mining Construction Personal Loan Mortgage Real estate Education Leasing Electronics Transportation Trading Off shore Engery Credit card Accommodation Others Postal & telcom Computer Manufacturing 1.0 [%] 0.5 0.0 -0.5 -1.0 -1.5 Tourism Low-2.0 NPL [%] Energy Real estate Public service Scientific Construction Margin) 1.5 Mining Personal lending [%] Mortgage Education 0.0 Manufacturing Small lending -0.5 Wholesaling 0.0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8 2.0 2.2 2.4 Low 2.0 Health care Transportation Other High • This study aggregated 18 banks' portfolio and analyze the relationship between EP margin and NPL • Result shows that there is a strong correlation and EP is linked to bank's asset quality and is good indicator of value creatoin Wholesaling Credit card Low -1.5 0.0 Low 0.1 0.2 0.3 0.7 NPL [%] 1.5 1.6 High • An even higher R square can be found for single bank analysis Eric on Chinese Banks Value Creation Analysis-en.pptx 48
  49. 49. B Appendix Why IRB approach Eric on Chinese Banks Value Creation Analysis-en.pptx 49
  50. 50. B Why IRB approach Current approach of credit RW doesn’t link to bank's asset quality. No linkage between both Current approach Credit RW & NPL High 1.50 1.45 R2 =0% 1.40 1.35 Mega Current approach Credit RW & average Chinese portfolio PD S & P Rating 3.8 High B+ 3.6 National R2 =0% 3.4 Regional 3.2 1.00 0.95 NPL 0.90 [%] 0.85 3.0 PD [%] 0.80 0.75 0.70 Low 0.65 0.60 2.2 2.0 BB- 1.8 1.6 1.4 Low 1.2 BB 1.0 0.00 100 Low RW[%] 100 High Low RW[%] Eric on Chinese Banks Value Creation Analysis-en.pptx High 50
  51. 51. B Why IRB approach Advance approach under Basel connects asset quality with risk weight FIRB approach Credit RW & NPL 1.5 High Mega 1.4 R2 =54% y = 0.0212x - 0.0106 1.3 National FIRB approach Credit RW & average Chinese portfolio PD S & P Rating 3.8 High B+ 3.6 R2 =54% 3.4 y = 0.0474x - 0.0239 Regional 3.2 1.2 3.0 1.1 NPL [%] 2.2 PD 1.0 [%] 0.9 2.0 BB- 1.8 0.8 1.6 0.7 1.4 Low Low BB 0.0 75 Low 1.2 80 85 90 RW[%] 95 100 105 High 1.0 75 Low 80 85 90 95 100 RW[%] Eric on Chinese Banks Value Creation Analysis-en.pptx 105 High 51

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